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Back to Future for VIX Curve Signals Volatility's New Normal

The first stages of restored market calm are underway, suggesting that a sky-high Cboe Volatility Index isn’t the new normal, unlike what so many observers warned about after the recent turmoil. Instead, traders are pricing derivatives in a way that suggests equity swings will soon ease even further.

Exhibit A: The VIX futures curve is back to normal. The curve tracks the implied volatility of the S&P 500 Index over time and typically forms an upward sloping shape -- called contango -- where contracts for months further out are priced higher than near-term ones. Put simply, traders usually demand a premium for the future since it’s less certain.

After the February turmoil, the curve inverted -- a tell-tale sign of stress called backwardation -- as investors forked over a premium to protect against ongoing volatility. If history is any guide, a shift back to contango means that we could expect the VIX to hover around 14 to 15, according to Pravit Chintawongvanich, head of derivatives strategy at Macro Risk Advisors.

“When we see the curve go back into contango after a long period of backwardation, a period of volatility normalization typically follows,” he said. “The curve un-inverting is a fairly reliable signal.”

While the VIX’s credibility has been called into question, the shape of its futures curve tends to be a strong indicator of where the volatility complex is going next, according to Chintawongvanich. Back to contango historically results in a 4 percent to 6 percent drop in near-term VIX contracts over the next month, he said.

The index itself rose to 16 in the early U.S. trading session on Thursday, but is headed toward its second consecutive week of declines. Meanwhile, the cost of hedging against a slide in the S&P 500 as measured by the spread in bearish-to-bullish options prices is falling back to its one-year average.

One thing’s for sure: The gap between implied and realized volatility in the S&P 500 is poised to tighten. That means either the market will get calmer, the VIX will rise, or a bit of both.

Goldman Sachs says uncertainty is still high as questions linger about technology sector regulation, trade tensions and central-bank policy. While economic factors still call for a lower vol environment, the VIX is unlikely to return to the unusually depressed levels of 2017, the bank’s portfolio strategy research team, headed by Christian Mueller-Glissmann, wrote in a report this week.

“The recent increase in vol has likely been exacerbated by technicals,” the note said. “Based on most of the macro, market and uncertainty indicators, it still appears somewhat unlikely that we have entered a new persistent high-vol regime.”